Trading The Gold-Silver Ratio

For the hard-asset enthusiast, the gold-silver ratio is part of common parlance, but for the average investor, this arcane metric is anything but well-known. This is unfortunate because there's great profit potential using a number of well-established strategies that rely on this ratio.

In a nutshell, the gold-silver ratio represents the number of silver ounces it takes to buy a single ounce of gold. It sounds simple, but this ratio is more useful than you might think. Read on to find out how you can benefit from this ratio.

How the Ratio WorksWhen gold trades at $500 per ounce and silver at $5, traders refer to a gold-silver ratio of 100. Today the ratio floats, as gold and silver are valued daily by market forces, but this wasn't always the case. The ratio has been permanently set at different times in history - and in different places - by governments seeking monetary stability. (For background reading on gold, see The Gold Standard Revisited.)

Here's a thumbnail overview of that history:

2007 – For the year, the gold-silver ratio averaged 51.

1991 – When silver hit its lows, the ratio peaked at 100.

1980 – At the time of the last great surge in gold and silver, the ratio stood at 17.

End of 19th Century – The nearly universal, fixed ratio of 15 came to a close with the end of the bi-metallism era.

Roman Empire – The ratio was set at 12.

323 B.C. – The ratio stood at 12.5 upon the death of Alexander the Great.

These days, gold and silver trade more or less in sync, but there are periods when the ratio drops or rises to levels that could be considered statistically "extreme." These "extreme" levels create trading opportunities. (To learn about why gold is a good investment, see 8 Reasons To Own Gold.)

How to Trade the Gold-Silver RatioFirst off, trading the gold-silver ratio is an activity primarily undertaken by hard-asset enthusiasts like "gold bugs". Why? Because the trade is predicated on accumulating greater quantities of the metal and not on increasing dollar-value profits. Sound confusing? Let's look at an example.

The essence of trading the gold-silver ratio is to switch holdings when the ratio swings to historically determined "extremes." So, as an example:

When a trader possesses one ounce of gold, and the ratio rises to an unprecedented 100, the trader would then sell his or her single gold ounce for 100 ounces of silver.

When the ratio then contracted to an opposite historical "extreme" of, say, 50, the trader would then sell his or her 100 ounces for two ounces of gold.

In this manner, the trader would continue to accumulate greater and greater quantities of metal, seeking "extreme" ratio numbers from which to trade and maximize his or her holdings.

Note that no dollar value is considered when making the trade. The relative value of the metal is considered unimportant.

For those worried about devaluation, deflation, currency replacement - and even war - the strategy makes sense. Precious metals have a proven record of maintaining their value in the face of any contingency that might threaten the worth of a nation's fiat currency.

Drawbacks of the TradeThe obvious difficulty with the trade is correctly identifying those "extreme" relative valuations between the metals. If the ratio hits 100 and you sell your gold for silver, then the ratio continues to expand, hovering for the next five years between 120 and 150, you're stuck. A new trading precedent has apparently been set, and to trade back into gold during that period would mean a contraction in your metal holdings.

What is there to do in that case? One could always continue to add to one's silver holdings and wait for a contraction in the ratio, but nothing is certain. This is the essential risk to those trading the ratio. It also points out the need to successfully monitor ratio changes over the short and medium term in order to catch the more likely "extremes" as they emerge.

Gold-Silver Ratio Trading AlternativesThere are a number of ways to execute a gold-silver ratio trading strategy, each of which has its own risks and rewards.

Futures InvestingThis involves the simple purchase of either gold or silver contracts at each trading juncture. The advantages and disadvantages of this strategy are the exact same: leverage. That is, futures trading is a very risky proposition for those who are uninitiated. Yes, you can play futures on margin. And yes, that margin can also bankrupt you. (For more insight, read Margin Trading.)

Exchange Traded Funds (ETFs)ETFs offer a simpler means of trading the gold-silver ratio. Again, the simple purchase of the appropriate ETF (gold or silver) at trading turns will suffice to execute the strategy.Some investors prefer not to commit to an "all or nothing" gold-silver trade, keeping open positions in both ETFs and adding to them proportionally. As the ratio rises, they buy silver; as it falls they buy gold. This keeps them from having to speculate on whether "extreme" ratio levels have actually been reached. (For more insight, see Gold Showdown: ETFs Vs. Futures.)

Options StrategiesOptions strategies abound for the interested investor, but the most interesting involves a sort of arbitrage, which involves the purchase of puts on gold and calls on silver when the ratio is high and the opposite when it's low. The "bet" is that the spread will diminish with time in the high-ratio climate and increase in the low-ratio climate. A similar strategy might be employed with futures contracts as well. Options permit one to put up less cash and still enjoy the benefits of leverage.The risk here is the time component of the option eroding any real gains made on the trade. Therefore, it's best to use long-dated options or LEAPS to offset this risk. (For more insight, read Option Spread Strategies.)

Pool AccountsPools are large, private holdings of metals that are sold in a variety of denominations to investors. The same strategies employed in ETF investing can be used here. The advantage of pool accounts is that the actual metal can be attained whenever the investor desires. This is not the case with metal ETFs, where certain very large minimums must be held in order to take physical delivery.

Gold and Silver Bullion and CoinsIt is not recommended that this trade be executed with physical gold for a number of reasons, ranging from liquidity to convenience to security. Just don't do it. (For more on gold as a commodity, read What Is Wrong With Gold?)

ConclusionThere's an entire world of investing permutations available to the gold-silver ratio trader. What's most important is to know one's own trading personality and risk profile. For the hard-asset investor concerned with the ongoing value of his or her nation's fiat currency, the gold-silver ratio trade offers the security of knowing, at the very least, that he or she always possesses the metal.

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